I beg to differ, when I hear the saying, "What you don't know won't hurt you." In investing, the contrary is true. Many investors have been misled into buying stocks with apparently low financial risk and strong balance sheets.

I will talk about the different types of hidden financial risks on the balance sheet here.

Operating Leases

There are two types of leases: finance leases, which appear on the balance sheet as financial liabilities, and operating leases, which only show up in the income statement as rental expenses. This does not reflect economic reality. The most common form of operating leases is rental of store space by retailers. Retailers are usually faced with two choices: 1) borrow money to own the store space and repay the debt over the period of the loan; or 2) pay rental expenses (fixed commitments) over the period of operation. In reality, the operating lease is no different from a loan. Operating lease expenses should be capitalized to approximate the value of debt on the books.

Debt of Unconsolidated Joint Ventures and Associates

Non-consolidated associates and joint ventures which are part and parcel of a complicated organizational structure for conglomerates allow management to hide debt off the books. This helps to improve the financial health metrics of a company.

Hybrid Securities

Common hybrid securities include preference shares, perpetual securities and convertible debt. Preference shares should be considered debt, as coupons on preferred shares have to be paid before dividends can be paid to ordinary shareholders. Similar to preference shares, perpetual securities are ranked ahead of equity in terms of distributions. The company has the option but not the obligation to repay or convert the perpetual securities at its callable date. Convertible debt, as its name suggests, is still debt, albeit more expensive. Furthermore, there is a possibility of conversion to equity and dilution of existing shareholders.

Operating Leverage

Leverage comes in pairs: financial leverage and operating leverage. All things being equal, a company with low operating leverage has a greater capacity to take on debt than a company with high leverage. A company with a high proportion of fixed costs to variable costs (costs which increase or decrease in line with sales) is said to have high operating leverage, which is potentially damaging like financial leverage (high levels of debt). For example, a company with all its costs varying with sales (variable costs) will see its costs drop in line with a decline in sales. This will help to buffer the hit to the net profit from any drastic fall in revenue.

About the author:

Mark Lin

Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap deep-value cigar-butts and wide-moat compounders. He publishes value investing case studies, investment checklists, and potential stock ideas on the Cheapskate Investing blog. He is also a regular contributor to various value investing communities.

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